Prepared by SM Nahidul Islam

Dept. of Finance & Banking

1. What is investment environment?

Answer: Investment environment can be defined as the existing investment
vehicles in the market available for investor and the places for transactions with
these investment vehicles. The main types of financial investment vehicles are
a. Short term investment vehicles (Certificates of deposit, Treasury bills, Commercial
paper, Bankers acceptances, and Repurchase agreements),
b. Fixed-income securities (Long-term debt securities, Preferred stocks),
c. Common stock, Speculative investment vehicles (Options, Futures etc.);
d. Other investment tools (Various types of investment funds, Investment life
insurance, Pension funds, Hedge funds).

2. What are the five steps to the investment process? What is the importance of each step to
the n tire process?
Answer: The investment process is concerned with how an investor should proceed in making
decisions about what marketable securities to invest in, how extensive the investments should be, and
when the investments should be made. The following five steps procedure for making
these decisions forms the basis of the investment process:
1. Set investment policy: Setting of investment policy is the first and very important step in
investment process. It identifies the investors risk tolerance and investment objectives. Setting
investment policy is important because it provides the general framework around which the
investment process is conducted.
2. Perform security analysis: Security analysis is at the center of the investment process. It
involves specifically identifying financial assets to be purchased for and sold from the
investors portfolio.
3. Construct a portfolio: Portfolio construction involves identifying those specific assets in
which to invest, as well as determining the proportions of the investor's wealth to put into each
one.
4. Revise the portfolio: Portfolio revision concerns the periodic repetition of the previous three
steps. It is necessary because investing is a dynamic process that responds to changes in
investment opportunities and the investors financial circumstances.
5. Evaluate the performance of the portfolio: portfolio performance evaluation is a feedback
and control procedure intended to help the investor examine whether his or her investment
program is meeting targeted objectives.

3. Why do secondary security markets not generate capital for the issuers of securities
traded in those markets?
Answer: Issuers receive the net proceeds of securities sales when their securities are initially sold
in the primary market. These securities represent claims on the issuing entities. For publiclytraded securities, these claims can be transferred through sales of the securities. This trading
among investors takes place in the secondary markets, where the issuers have no direct
involvement. When an investor sells his or her shares of a particular security in the secondary
market, the issuer has no means or right to receive any additional funds as a result of the trade.
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Prepared by SM Nahidul Islam

Dept. of Finance & Banking

4. Explain why the rate of return on an investment represents the investor's relative
increase in wealth from that investment?
Answer: The rate of return measures the wealth associated with a particular investment (or
investments) at the end of a period compared to the wealth associated with that investment at the
beginning of the period. Therefore the difference in the beginning and ending wealth figures
represents the increase in the investor's wealth derived from the investment. The rate of return
expresses this difference relative to the initial wealth associated with the investment.

5. Why are Treasury bills considered to be a risk free investment? In what way do investors
bear risk when they own Treasury bills?
Answer: Because the U.S. Treasury guarantees the payment of interest and principal on Treasury bills,
an investor can be certain of the return that he or she will earn on a Treasury bill investment. The
government has the unlimited authority to tax and print money to repay its debts. Therefore its ability
to make these promised payments is unquestioned.
This certain Treasury bill return, however, does not account for the effects of inflation. Although the
short maturity of Treasury bills makes this issue relatively unimportant, if inflation rose sharply and
unexpectedly during the time that an investor held Treasury bills, he or she would not be compensated
for the resulting lost purchasing power.

6. Does it seem reasonable that higher return securities historically have exhibited higher risk
than have securities that yielded lower returns? why
Answer: If one assumes that investors dislike risk, then higher-risk securities should exhibit higher
returns over long periods of time. If this relationship did not exist, and higher-risk securities offered
the same returns as lower-risk securities, then investors could not be induced to hold these riskier
securities. They could avoid additional risk and receive the same return by holding the lower-risk
securities. Such a situation could not be equilibrium. Prices of higher-risk securities would have to
adjust to provide investors with higher returns and therefore increase investors' willingness to hold
these securities.

7. Describe how life insurance companies, mutual funds, and pension plans each Act as
financial intermediaries.
Answer: Life insurance companies receive cash from individuals in the form of premiums. In
exchange, the insurance companies write policies promising to make payments in the event of the
death of the insured individual. The proceeds from the policy sales are primarily invested in stocks,
bonds, money market instruments, and real estate.
Mutual funds receive cash from investors and, in exchange, issue shares in the respective funds.
The proceeds from the funds' sales are invested in a wide variety of financial assets, with the specific
assets depending on the funds' particular investment objectives.
Pension funds receive employer (and sometimes employee) contributions and issue promises to
pay retirement benefits in exchange. The contributions are primarily invested in stocks, bonds, and
money market instruments.
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Prepared by SM Nahidul Islam

Dept. of Finance & Banking

8. What factors might an individual investor take into account in determining his or her
investment policy?
Answer: Many factors could influence an investor's investment policy. Some obvious factors would
include the investor's financial objectives (for example, saving for retirement or building a child's
college fund), the investor's willingness to bear risk, the investor's current financial circumstances, and
the investor's investment time horizon (partly a function of age and career status).

9. Distinguish between technical and fundamental security analysis

Answer: Technical analysis attempts to forecast the movement in the prices of securities based
predominately on historical price trends in those same securities.
Fundamental analysis seeks to determine the intrinsic values of securities based upon estimates
of the securities' future cash flows. These intrinsic values are compared to existing market prices to
estimate current levels of mispricing.

Glossary
Investment: The sacrifice of certain present value for (possibly uncertain) future value.
Investment Adviser: An individual or organization that provides investment advice to investors.
Savings: Foregone consumption. Also, the difference between current income and current
Real Investment: An investment involving some kind of tangible asset, such as land, equipment, or
buildings.
Financial Investment: An investment in financial assets.
Primary Market: The market in which securities are sold at the time of their initial issuance.
Secondary Market: The market in which securities are traded that have been issued at some previous
point in time.
Treasury bill: A pure-discount security issued by the U.S. Treasury with a maximum term-to maturity
of one year.
Risk: The variability of expected rate of return associated with the given assets.
Security Market: See Financial Market.
Money Markets: Financial markets in which financial assets with a term to maturity of typically one
year or less are traded.
Capital Markets: Financial markets in which financial assets with a term to maturity of typically
more than one year are traded.
Financial Intermediary: An organization that issues financial claims against itself and uses the
proceeds of the issuance primarily to purchase financial assets issued by individuals, partnerships,
corporations, government entities, and other financial intermediaries.
Fundamental Analysis: A form 01" security analysis that seeks to determine the intrinsic value of
securities on the basis 01" underlying economic factors. These intrinsic values are compared with
current market prices to estimate current levels of mispricing.
Technical Analysis: A form of security analysis that attempts to forecast the movement in the prices of
securities primarily on the basis of historical price and volume trends in those securities.
Selectivity: An aspect of security analysis that entails forecasting the price movements of individual
securities.
Timing: An aspect of security analysis that entails forecasting the price movements of asset classes
relative to one another.
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Prepared by SM Nahidul Islam

Dept. of Finance & Banking

Problems and Solution

1. Colfax Glassworks stock currently sells for $36 per share. One year ago the stock Sold for
$33.The company recently paid a $3per share dividend. What was the Rate of return for
an investor in Colfax stock over the last year?
Solution: The return on an investment, as shown in Equation (1.1) in the text, is given by:
ROR

Ending Wealth Beginning Wealth

Beginning Wealth

In the case of Colfax stock:

ROR = ($36 + $3 - $33)/($33)
= .182 = 18.2%
2. Flit Cramer owns a portfolio of common stocks that was worth $150,000 at the Beginning
of the year. At the end of the year, Flit's portfolio was worth$162,000. What was the
return on the portfolio during the year?
Solution: Using the formula for the return on an investment shown above, in the case of Flit's
portfolio:
($162,000 - $150,000)/ ($150,000) = .080 = 8.0%
3. At the beginning of the year, Ray Fisher decided to take $50,000 in savings out Of the bank
and invest it in a portfolio of stocks and bonds; $20,000 was placed into common stocks
and$30,000into corporate bonds. A year later, Ray's stock and bond holdings were worth$
25,000 and $23,000, respectively. During the Year $1,000in cash dividend was received on the
stocks, and $3,000in coupon Payments was received on the bonds.(The stock and bond income
was not reinvested in Ray's portfolio.)
a. What was the return on Ray's stock portfolio during the year?
b. What was the return on Ray's bond portfolio during the year?
c. What was the return on Ray's total portfolio during the year
Answer: Using the formula for the return on an investment shown above, in the case of Ray's
portfolio:
a.

($25,000 - $20,000 + $1,000)/($20,000) = .300 = 30.0%

b.

($23,000 - $30,000 + $3,000)/($30,000) = -.133 = -13.3%

c.

($48,000 - $50,000 + $4,000)/($50,000) = .040 = 4.0%

Prepared by SM Nahidul Islam

Dept. of Finance & Banking
4. In 1951the Treasury Department and the Federal Reserve System(the Fed) Came to an
agreement known as the "Accord," whereby the Fed was no longer Obligated to peg
interest rates on Treasury securities. What were the average returns and standard
deviations on Treasury bills for the ten-year periods from 1942 to 1951and from 1952 to
1961? From these data, does it appear hat the Fed did indeed stop pegging interest rates?
(See endnote2 for the formula for Standard deviation.)
Answer: Based on Table 1.1, the average annual return on Treasury bills during the period 19421951 was 0.67%. From 1952-1961 the average annual return was 2.08%.
The standard deviation of Treasury bill returns during 1942-1951 was 0.45%. From 1952-1961
the standard deviation was 0.72%.
Given the increase in Treasury bill return volatility from the first period to the second, it does
appear that the Fed stopped pegging interest rates in 1951.
5. The following table shows the annual returns on a portfolio of small stocks during the20year period from 1976 to 1995.What are the average return and standard deviation of
this portfolio? How do they compare with the 1976-1995. Average return and standard
deviation of the common stock portfolio whose annual returns are shown in Table1.1?
1976: 57.38% 1981: 13.88% 1986: 6.85% 1991: 44.63%
1977: 25.38
1982: 28.01
1987: -9.30
1992: 23.35
1978: 23.46
1983: 39.67
1988: 22.87
1993: 20.98
1979: 43.46
1984: -6.67
1989: -21.56 1994: 3.11
1980: 39.88
1985: 24.66 1990: -21.56 1995: 34.46
Answer: The average annual return on small stocks during 1976-1995 was 21.23%. The standard
deviation of small stock returns during this period was 19.94
The average annual return on common stocks during 1976-1995 was 15.37%. The standard
deviation of common stock returns during this period was 13.65%.
6. Financial advisers often contend that elderly people should invest their portfolios more
conservatively than younger people. Should a conservative investment policy for an
elderly person call for owning no common stocks? Discuss the reasons for your answer.
Answer: It is probably not advisable for an elderly person to hold a portfolio that includes no
commons stocks. Common stocks have by far outperformed other asset classes historically.
Moreover, compared to returns on bonds and money market investments, common stocks are the only
asset class to historically produce a large premium over inflation. An elderly person must be
concerned about maintaining the purchasing power of his or her investments. Given their historical
performance, common stocks seem to be well-suited to helping maintain that purchasing power. Just
what proportion of the portfolio should be held in common stocks is another matter.
8. Why are corporate bonds riskier than U.S. government bonds?
Answer: Corporate bonds, no matter how creditworthy the issuer, always bear the risk that the issuer
might default on its debts. The U.S. government, on the other hand, can always raise taxes or print
money to cover its debt obligations. Therefore, as discussed in the answer to the previous problem, the
government has an unlimited ability to satisfy its debt obligations.
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Prepared by SM Nahidul Islam

Dept. of Finance & Banking
9. Why might it be reasonable to believe that including securities issued in foreign Countries
will improve the risk-reward performance of your portfolio?
Answer: Foreign security returns do not necessarily move in the same direction as returns on U.S.
securities. For that reason, including them in a portfolio will tend to dampen the ups and downs of the
portfolios total returns. This effect is known as diversification and can significantly improve the risk
performance of a portfolio. In addition, some investors contend that returns on foreign securities are
generally higher than those on comparable U.S. securities. While this contention is controversial, an
investor who believes it could increase both the expected risk and return performance of his or her
portfolio by including foreign securities.
10. Why does it not make sense to establish an investment objective of making a lot of money"
Answer: Because returns on financial assets are directly related to risk, establishing an investment
objective of "making a lot of money," or equivalently, maximizing returns, might entail inordinate
levels of risk. More appropriate would be an investment objective that jointly establishes desired
levels of return and risk.